Debt factoring or factoring of receivables is the process where an entity sells its receivables (unpaid invoices) to another entity. The entity that purchases the receivables is known as a “factor”, who then manages the receivable balances and collects the cash from customers.
Factors are specialists in management and collection of receivables. If a company does not want the headache of chasing customers for collection of receivable balances, it can leave this task for the specialists, for which the factors will charge some fee for their service. There can be different arrangements, but usually the factor pays 80-85% of the receivable balances upfront. When the customer pays, factor collects the full amount, and pays the remaining 15-20% of the receivable balance after deducting its fee for factoring services.
Types of debt factoring
There are two types of debt factoring.
- Debt factoring with recourse
- Debt factoring without recourse
Debt factoring with recourse
In debt factoring with recourse arrangement, the factor has the option to return any unpaid balances to the company from which it purchased the receivables. It means that credit risk associated with the receivables is still with the company as in the case of default, the company would suffer the loss.
Debt factoring without recourse
In debt factoring without recourse arrangement, the factor does NOT have the option to return any unpaid balances to the company from which it purchased the receivables. It means that credit risk associated with the receivables is assumed by the factor as in the case of default, the factor would bear the loss.
Accounting of debt factoring
Accounting treatment of debt factoring will be based on the answer to the following question.
Who bears the risks and rewards related to the receivables? For instance, if a customer pays late or defaults, who bears the risks of losses? Similarly, if a customer pays early, who will benefit from the early realization of the receivables.
In debt factoring with recourse, the risks and rewards are not transferred to the factor. Therefore, it cannot be treated as sale of receivables as per substance over form principle. The receivable balances will not be derecognized by the company in such case. Cash received from the factor will be treated as a loan, and the services charges as finance cost.
In debt factoring without recourse, the risks and rewards are transferred to the factor. Therefore, it is treated as sale of receivables. The receivable balances are derecognized by the company in such case. Factor’s service charges are recorded as administrative expense in the income statement.